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May 2007

The Truth About Hedge Funds

By: Ranjan Bhaduri

What was once regarded as wild investing by high-rolling cowboys, hedge funds have evolved into a widely-accepted, investment vehicle that is adding value to affluent investors and institutional portfolios. There are more than 8,000 hedge funds worldwide, managing in excess of $1 trillion. This has roughly doubled in the past five years. Canada has helped contribute to this growth. There are more than 200 hedge funds in Canada with more than $15 billion in assets under management. Moreover, Canadaʼs biggest pension plans, such as the Ontario Teachersʼ Pension Plan and the Caisse de dépôt et placement du Québec, have sizeable allocations to hedge funds.

Yet, despite the fact that hedge funds have become a staple part of many of the worldʼs best pensions and endowments, much misconception still exists about these investment strategies.

Essentially, a hedge fund is a private investment program where the manager seeks positive returns by exploiting investment opportunities. This broad definition means that there are several different kinds of hedge funds with many different types of trading strategies across a wide range of instruments.

Incidentally, the word ʻhedgeʼ in hedge funds is, in general, misleading, since a hedge fund need not be hedged. Some hedge risks, others donʼt.

Truth about hedge funds

The playing ground has become vast for hedge funds. Hedge funds seem to be nosing their way into everything – equity, fixed income, currency, commodities, energy, loans, distressed debt, receivables, structured finance, and reinsurance. There are hedge funds that are run by one or two people and hedge funds that are as large as investment banks. Hedge funds are trading everywhere – North America, Europe, Asia, Middle East, Australia, Africa, and South America. Thus, hedge funds pretty much come in all sizes and shapes and, most importantly, all risk levels. This means that while there are hedge funds that are very risky, there are also hedge funds that have very little risk.

Hedge Fund Blow-ups

Hedge funds have long had a shroud of mystery and intrigue around them. Part of the image of many hedge funds is to be secretive and to fly under the radar. Unlike equities, which regularly have news conferences or press releases, the media does not get as much access to hedge funds. Consequently, when there is news, itʼs often BIG news such as Long Term Capital. This was a hedge fund that had an all-star team which included a couple of Nobel Laureates. Its sensational blow-up required the U.S. government to intervene in order to avoid a global financial catastrophe. The many hedge funds that quietly generate solid returns in a risk-controlled way, do not generate headlines.

Hedge fund managers face fewer constraints (both regulatory and in their investing domain) than mutual fund managers. Since the domain of investment possibilities for hedge funds is much larger, and the regulatory costs and constraints are less, it makes sense that a smart hedge fund manager who has a good risk management framework in place, should be able to add value.

However, the biggest strength is also the biggest weakness. Due to the fact that the investing space is so open and that there are not as many regulatory safety checks in place for hedge funds, the safety net is a lot thinner. Consequently, there is a lot less protection for hedge fund managers who do not have a good risk management infrastructure or who mistakenly believe that they have a winning strategy. These hedge funds are vulnerable to losses.

Is this reason enough to avoid the hedge funds space altogether? Only if one reasons that equities and bonds should be avoided altogether as well. After all, blue-chip stocks such as Enron went out of business. And the tech meltdown at the start of this millennium saw Nortelʼs stock go from well above $100 to flirting with penny stock status. Even fixed income has not been immune from the blow-ups. Corporate bond defaults helped initiate the creation of credit derivatives. Governments such as Russia and Argentina have defaulted on sovereign bonds and this was considered an impossibility before it occurred. Finally, when a hedge fund blows up, often there are winners on the other side since most hedge funds are playing in zero-sum games (what a hedge fund loses, another party wins).

The fact that there are so many new hedge funds forming means, just like any business, that many of them will not survive.

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